This is my first post on this board but I have been reading it at every opportunity for the past 2 months and can honestly say this site is one of the best on the internet. I'm still very new to investing but I've learned so much here, and want to thank the terrific posters in this community.

My question:

I'm considering putting my excess earnings into California Muni Bond funds. The current SEC Yield of Vanguard California Intermediate-Term Tax-Exempt Fund Investor Shares (VCAIX) is 1.89%. I'm in a high tax bracket so the tax-exempt nature of this fund makes it look better to me than short term CDs or other low-risk alternatives. I am willing to accept the greater risk of this bond fund losing value, as compared to CDs. BUT, does this 1.89% yield account for the effect of capital gains? If I invest in VCAIX and sell within 2 years, even if VCAIX yield stays at 1.89% will the effect of capital gains taxation drop my effective yield below what I could have earned on a taxable 1.75% CD?

For context, I'm looking for a place to put my money where I can use it in 1-5 years. There is a 30% chance I'll want to use these funds as a down payment for a 2nd property within the next 2 years. There is a 90% chance I'll be paying college tuition costs in 5 years. So I don't want to invest in something that will lose 50% of its value but I can handle slightly more risk than a CD (if I lose 10% it's not the end of the world).

If the yield on VCAIX (or VCADX, its Admiral shares counterpart) is even close to the same at the points of purchase and sale, then any capital gain taxation will be de minimis to your purposes. Still, comparison to a ~1-2 year CD is not ideal because the interest rate risks are not well matched.

If you definitely will not need the money back in 2 years, your savings after 2 years would be higher, as it seems that you live frugally; appropriate for the BH philosophy. Looks like you should have the flexibility of not selling the CA muni fund and use some of your savings or CD money for down payment?

If the yield of a bond fund does not change, and the fund's share price increases so that you have a capital gain, then its return must have been higher than the yield. (This is not quite true if the fund holds bonds with a coupon lower than the yield, which may happen if bond yields rose after the fund bought the bonds.)

This is a common situation. Suppose that a fund holds bonds with a 6-10 year duration, and 5-year bonds yield 2%, increasing 0.1% for each additional year.. The fund will report a 2.3% yield, and an 8-year duration. If the fund holds all its bonds for one year, and rates don't change, the duration decreases to 7 years and the yield decreases to 2.2%. The 0.1% decline in the yield on bonds held by the fund results in a 0.75% price increase. When the fund sells its 5-year bond yielding 2% to buy a new 10-year bond yielding 2.5%, getting back to its start-of-year portfolio, that 0.75% becomes a capital gain. You thus get a 3% return on the fund (average yield during the year was 2.25%), and retain the same yield next year.

As you can see, in some years the capital return could be larger than the income return, while in other years the capital return could be negative--perhaps negative enough to more than offset the income return. Due to the uncertainty of the return, especially over one or two years, I would not use this fund for a time horizon shorter than 5-10 years (the duration of the fund is 5.6 years). I do own shares of this fund and the CA long-term muni fund, but consider them long-term holdings.

I've been finding good deals in individual AAA rated municipal bonds in the 1.5-3 year range. Interestingly, I'm finding better deals in non-CA munis. I've been getting taxable equivalent yields in the 2.3-2.6% range for 1.5-2.0 year Munis, and my tax rates are a bit lower than yours. Clearly these are far superior to even the best CD rates in a taxable account.

Of course it's more work to buy individual Munis, and you have to watch out for a few things, like extraordinary calls and sinking funds. I've just been buying non-callable bonds with sinking-fund protection, and rated AAA by Moody's or S&P. I also avoid housing and hospital bonds, since these have had by far the highest default rates historically, and housing bonds often have extraordinary calls.

Also, I've found that the deals at Fidelity have been significantly better than at Vanguard (unfortunately after buying some from Vanguard), with yield advantages of 5-10 basis points, and a generally larger selection. Also, Fidelity charges $1 per bond regardless of account value, while Vanguard charges $2 unless you are Flagship Select or higher (at least $500K in Vanguard products).

If you want to stick with funds, then the Short-Term and/or Limited-Term muni funds might be more appropriate for your timeframe, even though they are taxable by CA. I pretty sure I'm doing better with individual munis (definitely if you compare to SEC yields), but I still might plunk some into one or both of these funds for the flexibility and liquidity. Even the CA tax-exempt money market fund has gotten to the point where it's a better deal for you than say the no-penalty 1.75% CD that Ally was offering until today (I calculated the TE yield as about 1.85% for me), and of course with the MM fund you have no term risk.

So I'd at least plunk whatever money your thinking about into the CA tax-exempt money market fund while you mull this over.

As you can see, in some years the capital return could be larger than the income return, while in other years the capital return could be negative--perhaps negative enough to more than offset the income return. Due to the uncertainty of the return, especially over one or two years, I would not use this fund for a time horizon shorter than 5-10 years (the duration of the fund is 5.6 years). I do own shares of this fund and the CA long-term muni fund, but consider them long-term holdings.

I was looking at my Vanguard account last week and noticed that the capital gains was exactly $0 on VCAIX that I bought about 6 months ago. I found this strange as I though I'd have some capital gains and this might be an error, but it turned out to be perfectly accurate. The price on the day I looked was exactly the same as the price I bought it. I had gone up a bit and with the recent drop, come right back down. In the meanwhile, every month, I've been getting my tax free ~1.89% distribution, so I'm happy. I'm just being lazy, but I'm happy to receive an average return. No need to spend time to optimize for a fraction of a percent and/or worry about tax issues. I do wonder that if folks are able to improve their returns by making optimizations and getting better than average returns that I'm getting, who's left to get less than average returns? Or is everyone who's optimizing causing my average return to fall?

As you can see, in some years the capital return could be larger than the income return, while in other years the capital return could be negative--perhaps negative enough to more than offset the income return. Due to the uncertainty of the return, especially over one or two years, I would not use this fund for a time horizon shorter than 5-10 years (the duration of the fund is 5.6 years). I do own shares of this fund and the CA long-term muni fund, but consider them long-term holdings.

I was looking at my Vanguard account last week and noticed that the capital gains was exactly $0 on VCAIX that I bought about 6 months ago. I found this strange as I though I'd have some capital gains and this might be an error, but it turned out to be perfectly accurate. The price on the day I looked was exactly the same as the price I bought it. I had gone up a bit and with the recent drop, come right back down.

Sure, that can happen, but the capital return can have a meaningful impact on the total return, even over a fairly long time period. I just checked, and for the last 10 years I've held the CA int-term muni fund, capital return has added about 17% to the total annualized personal return of 4.2%. So that's about an additional 0.7 percentage points of annualized return, without which my return would have been about 3.5% annualized.
In dollar terms, that would mean an additional $8,540 on a total return of $50,000.

In a rising interest rate environment, that could subtract a similar amount from the return, but of course the rising yields will have a positive effect over time.

Of course over shorter timerframes the impact of capital return can be much more significant. Over the last year capital return has added about 37% to my total return.

By contrast, over the last three years capital return subtracted about 8%, and over the last five years it has subtracted about 7%.